Active Portfolios: Diversification Across
Trading Strategies
Author(s)
C. Murray
Abstract
Several characteristics of a firm and its past return have been shown to be useful
in predicting future returns, leading to long-short trading strategies with positive
expected return using no invested capital. I develop the idea of active portfolios,
which treat these long-short strategies as investable assets. I show that, since the
returns from these long-short strategies are largely uncorrelated, active portfolios
which make simultaneous bets on several long-short strategies have Sharpe
ratios several times that of the market and extremely attractive return
characteristics. I argue that this is because the diversification achievable in
active portfolios exceeds that attainable through traditional sources of
diversification.
Keywords: long-short trading strategies, value, momentum, diversification.
1 Introduction
Researchers have found a large number of long-short trading strategies that earn
significant return with no invested capital. These strategies can be roughly
categorized as momentum [5, 11], value [3, 8, 9, 12], firm size [6, 8] and reversal
on a long [2, 7] and short [10, 13] time scale. These strategies sort stocks by one
of the above criteria every month, then go long a portfolio of stocks that strongly
exhibit that criteria and short a portfolio that weakly exhibit it. The return is the
spread between the two portfolios. Different studies have used different
samples, methodologies, and time periods to find different return spreads from
these trading strategies, but a large amount of research supports the view that the
above strategies have positive expected return.
I look at the performance of \“active” portfolios, which treat long-short trading
strategies as investable assets and which follow several strategies at once. They
are \“active” because the trading strategies turn over some of their capital every
Keywords
long-short trading strategies, value, momentum, diversification.
Related Book
Other papers in this volume
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